This paper attempts to examine the economic impact of liberalization of labor market in China on the aggregate welfare of the country and the rest of the world. The liberalization in labor market is characterized by the abolition of a household registration system that prohibits permanent migration from rural area to urban area in China. This migration restriction has been maintained for more than 45 years and is going to be abolished in the near future. The hypothesis tested is that the a free mobility of the rural surplus labor into China’s urban industrial sector will have a significant impact on production, employment and trade patterns both in China and in the rest of the world, particularly in the labor-intensive industries. This will result in a large-scale restructuring of the world economy in line with regional specialization and comparative advantage. Several policy scenarios are simulated by an applied general equilibrium model (the GTAP Model). These scenarios include a net increase in China’s unskilled labor force in urban labor intensive manufacturing sector, a transfer of the labor force from the agricultural sector to manufacturing sectors, a combination of both labor market liberalization and capital market liberalization. To capture the regional and sectoral impact of the change, the world economy is divided into 10 regions and 10 sectors. The net welfare effects of these liberalizations are positive for the world as a whole in general, and for China in particular. Policy implications are discussed and suggestions are offered to the Chinese authority to liberalize the Chinese labor and capital markets further.